THE BEAR'S
LAIR Regulating the
un-regulatable By Martin
Huchinson
The complex and ongoing collapse
in the US securities markets and the
extraordinarily expensive demise of Northern Rock
in Britain signify gross failures of banking
regulation on both sides of the Atlantic. As
regulation has grown more complex, it has become
notably less effective. In the
post-financial-holocaust world that we will
shortly enter, how should it be done?
Traditionally, banking regulation was
quite simple because it was enforced by
oligopolistic markets. The Bank of England was the
universal regulator; it had little statutory power
but over a "cup of tea" could enforce compliance
with the most conservative banking standards. The
strength of the Bank of England lay in its
informal control of the British banking "club" - a
bank that defied the Bank
of
England would find itself in severe difficulties
in obtaining lines of credit with other banks, or
in attempting major corporate business.
The United States is in some ways a more
interesting example. From 1791 to 1836, the First
and Second Bank of the United States could and did
enforce banking standards by determining at what
price they would take the notes of other banks.
Since in order to finance trade a bank’s notes
needed to be acceptable in distant centers, a bank
that lent over-aggressively would find the Bank of
the United States no longer willing to accept its
notes at face value, which would substantially
increase its costs of financing trade.
From 1837, with the Bank of the United
States no longer in existence, this system broke
down - the free market in money reigned supreme,
with notes trading at varying discounts and no
central clearing house. Then in 1862 the National
Banking Act instituted regulated national banks,
and provided for a truly common currency. Around
1900, JP Morgan exercised a similar influence to
the Bank of England over the US financial system,
although US banks whom Morgan thought lacked
"character" were always better able to survive
than British banks on whom the Bank of England
frowned.
This admirable system of highly
informal regulation on both sides of the Atlantic
began to break down in the 1920s, when US houses
wrecked the international issues market by being
over-aggressive in peddling loans to Latin
America.
However, the New Deal brought
tighter banking regulations to both sides of the
Atlantic and the combination of tight statutory
regulation in the US and loose regulation and
continuing oligopoly in Britain worked well until
the middle 1960s. At that point, the invention of
the euro-market, together with the replacement in
1966 of a very strong Bank of England Governor
Rowland, Lord Cromer with a series of weak ones
brought the existing regulatory system for the
first time into question. The US houses, tightly
regulated at home, found they could operate much
more freely in the European market, and those
without banking licenses needed pay little heed to
the Bank of England’s opinion. The result, from
1969 in both Britain and the US was a series of
unpleasant scandals and bankruptcies followed by a
decade-long downturn in the financial services
business.
The British government responded
by moving to a statutory system of regulation
similar to the US; this had the effect of wiping
out its merchant banking community, which had
existed for over 200 years. Internationally, the
unexpected, mishandled and litigation-rich
collapse of Bankhaus ID Herstatt in 1974 led to a
demand for internationally agreed capital
requirements and trading standards.
The
first Basel Accord, which standardized capital
requirements worldwide, was fairly simple but took
little account of the financial innovations that
were already sweeping the banking business. It
went into effect in 1988 and had a notably useful
effect in emerging markets, where local banks were
discouraged from overleveraging themselves, as had
previously been their practice.
However
the major international banks regarded the 8%
capital requirement imposed by Basel as impossibly
onerous, and believed that the Accord
unnecessarily restricted their move into
profitable new areas of finance. Consequently,
from the middle 1990s they vigorously lobbied the
Basel Committee for a new agreement, the Basel II
Accord, which would allow them to carry out their
own risk management and leverage themselves more
than their smaller brethren. Unsurprisingly, their
lobbying worked.
Equally unsurprisingly,
the new capital standards haven't. The risk
management methodology blessed by Basel II, that
of Value-at-Risk, has been found to be an
excellent way of measuring risk - except when
markets are actually risky. Consequently the
capital requirements imposed by VAR in the name of
Basel II are so much waste paper.
Also,
large banks have been proven to be no more
sophisticated than small ones. It is notable that
the only difference between the subprime
write-offs of Merrill Lynch and Citigroup, among
the largest and most sophisticated banks in the
industry, and Sachser LB, a German landesbank so
insignificant that it played no measurable
economic role even in its home region, was an
extra zero tagged onto the end of Citi's and
Merrill's loss figures. Naturally, Sachser LB had
to be "rescued" by a larger partner - but so did
Citi and Merrill, the larger partners in their
case being several dubious sovereign wealth funds.
The theoretical edifice of modern finance
was magnificent and apparently indestructible. Its
implosion in the last six months has been nothing
short of spectacular, triggering misguided
predictions and analyses by those in authority
worthy only of Mother Shipton. To say modern
finance's destruction resembles the sinking of the
Titanic would be trite, and in any case insults
the magnificent engineering of that doomed but
beautifully built and almost flawless vessel.
Instead, let us remain with the nautical motif,
and compare it with the sinking of the British
warship HMS Captain in 1870.
Unlike the
Titanic, HMS Captain was seriously flawed as an
engineering concept. She was an experimental
ironclad battleship; her designer, Captain Cowper
Phipps Coles, designed her with revolutionary
turret guns and a freeboard that was deliberately
kept exceptionally low, even by the standards of
the early ironclads (American readers will
remember that the USS Monitor, eight years
earlier, also suffered from this flaw).
As
well as screw propulsion, the captain was equipped
with a full set of masts and sails, which together
with the turret guns made her top-heavy. Her flaws
were magnified by shoddy construction; she came in
870 tons over design and with a freeboard of only
6 feet 6 inches instead of the planned 8 feet.
Consequently, while stable in calm seas, she
overturned on September 7, 1870 in a moderate gale
in the Bay of Biscay, drowning all but 17 of her
crew of 500. In its poor design, shoddy
construction, misguided experimentation and
general un-seaworthiness modern finance is the
Captain not the Titanic; further use of the
prototype should be scrupulously avoided.
The system of financial regulation needs
to be completely reworked. No longer should the
behemoths of the market be allowed to give
themselves greater privileges than medium-sized
banks. Nor should untested financial theories be
incorporated into regulations until a major bear
market has proved them seaworthy.
Instead,
all assets for which a bank is responsible should
be carried on its balance sheet, as should the
market value of all liabilities, contingent or
otherwise, even if they are offset by
corresponding assets. Strict regulations should be
imposed on maturity and currency mismatches, and
trading in equities should not be permitted by
institutions whose deposits are guaranteed. No
exceptions should be permitted to these
regulations.
Overleveraged blunderers like
Fannie Mae and Freddie Mac should not be allowed
to evade banking regulation; since they do banking
business, they are banks, albeit banks with an
entirely unhealthy concentration of risk in one
sector.
Rather than bury financial
innovation in the inner depths of institutions so
large it will be either lost or misused, a
conscious attempt should be made to recreate the
organizations that acted as primary financial
innovators for two centuries: the merchant banks.
Subject to tight banking regulations
themselves, and limited in the amount of capital
they could deploy, these institutions should be
certified by the central bank and, once certified,
granted some privilege similar to the discounting
of acceptances that would put them on the same
basis of creditworthiness as the behemoths.
They would thus be the main centers of
financial innovation, albeit on a modest scale,
ceding the new markets they created to the
behemoths when those markets had become
commoditized and well understood even by the
slow-witted behemoth managers - in other words
performing the same function as the pre-1986
London merchant banks, without necessarily being
located in London.
Institutionally, both
London and New York’s regulatory systems have been
found wanting. In London, the Northern Rock case
has proved it hugely damaging to separate the
regulation of institutions from the responsibility
for their bailout. The Financial Services
Authority, responsible for regulation, was at no
financial or career risk when things went wrong.
Conversely the Bank of England was called on to
bail out an institution that it had no hand in
regulating. The British taxpayer, the ultimate
source of bailout funding, was not consulted at
any point.
In New York, the main problem
has been the conduct of monetary policy itself,
which has been inordinately lax for over a decade.
The Fed's dual mandate, to preserve price
stability and full employment, is in practice an
excuse for politicians to browbeat the monetary
authorities into excessive laxity, while the
abandonment of monetarism by the Fed in 1993
allowed spurious justifications for excessive
money creation to multiply like weeds.
The
Fed must be given a mandate of price stability
alone, and must be instructed that, while the
United States may not currently be on a gold
standard, monetary aggregates, narrow and broad,
should not be allowed to grow faster than nominal
gross domestic product and ideally not
significantly faster then real GDP.
The
objection that monetary aggregates cannot be used
as a guide to policy is entirely true in the short
run, entirely false in the long run. Whereas a
particular monetary aggregate may well grow
exceptionally fast or exceptionally slowly for six
or even 12 months, off-target growth over an 18-24
month period indicates that something has gone
seriously wrong, and that policy changes need to
be made.
In the case of dollar M3, the
aggregate began to grow excessively rapidly from
about February 1995, rising 7.0% in the year to
February 1996 and 7.6% in the following year, both
significantly faster than the growth of nominal
GDP (4.5% in 1995 and 5.6% in 1996).
By
late 1996 it should have been obvious that tighter
policy was needed, even if an exuberant stock
market boom had not also hinted this. Indeed, it
was obvious: Fed Chairman Alan Greenspan's
"irrational exuberance" speech was made on
December 4, 1996. At that point, Greenspan should
not have been permitted to ignore the matter; he
should have been compelled by statute to tighten
monetary policy until M3 growth once again fell
below the growth in nominal GDP.
Needless
to say, good central bank legislation would also
not have permitted the Fed to cease reporting M3
in March 2006, just as the awful effects of its
excessive expansion were beginning to become
glaringly apparent. Without the compass of broad
money statistics, proper monetary steering becomes
impossible.
Thus in New York as well as
London, banking regulation needs to be overhauled.
The objective should be a system similar to that
of the pre-1998 German Bundesbank, in which
monetary credibility was total and regulatory
oversight draconian.
Bankers are by nature
greedy people who will use any loopholes in
regulation to enrich themselves, without regard to
the risks to the public. Better therefore that
regulation should be draconian and without
loopholes than that the spurious "innovation" of
the past three decades be allowed to continue.
Martin
Hutchinson is the author of Great
Conservatives (Academica Press, 2005) - details
can be found at www.greatconservatives.com.
(Republished with permission from
PrudentBear.com . Copyright 2005-07 David W Tice
& Associates.)
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